CHFC 2018 Annual Report

Allowance for Loan Losses We use a defined methodology to quantify the necessary allowance for loan losses ("allowance") and related provision for loan losses, but there can be no assurance that the methodology will successfully identify and estimate all of the losses that are inherent in our loan portfolio. Our methodology uses our historical loss experience (net charge-offs) adjusted for qualitative factors, including trends in credit quality, composition of and growth in our loan portfolio, and the overall economic environment in our markets. These qualitative factors include many estimates and judgments. As a result, we could record future provisions for loan losses that may be significantly different than the levels that have been recorded in the three-year period endedDecember 31, 2018. Note 1 and Note 5 to our Consolidated Financial Statements further describe the methodology we use to determine the allowance. In addition, a discussion of the factors driving changes in the amount of the allowance is included under the subheading "Allowance for Loan Losses" in "Management's Discussion and Analysis of Financial Condition and Results of Operations." Our allowance has two components: (1) the allowance for loan losses (including both our originated and acquired loan portfolios) and (2) the reserve for unfunded credit commitments. Unfunded credit commitments include items such as letters of credit, financial guarantees and binding unfunded loan commitments. The allowance represents management’s estimate of probable credit losses inherent in our loan and unfunded credit commitment portfolios as of period end. We calculate the allowance with the objective of maintaining a reserve sufficient to absorb losses inherent in the loan portfolio. We consider the allowance to be a critical accounting estimate because it requires significant judgment and the use of estimates to determine the amount and timing of expected cash flows on acquired loans and impaired loans, the collateral values on impaired loans, and estimated losses on pools of homogeneous originated loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The principal assumption used in deriving the allowance is the estimate of a loss percentage for each type of loan. In determining the allowance for the originated loan portfolio and the related provision for loan losses, we consider three principal elements: (1) valuation allowances based on probable losses identified during the review of impaired loans, (2) reserves, by loan classes, on all other loans based on six-years of historical loan loss experience, loan loss trends and consideration of estimated loss emergence periods, and (3) a reserve for qualitative factors that take into consideration risks inherent in the originated loan portfolio that differ from historical loan loss experience. We have a loan review function that is independent of the loan origination function. At least annually, the loan review function performs a detailed credit quality review, including analysis of collateral values, of the majority of the loans in our commercial loan portfolio, with a particular focus on larger balance loans and loans that have deteriorated below certain levels of credit risk. In many cases, the estimate of collateral values includes significant judgments and assumptions. The following section, "Accounting for Acquired Loans", describes the process for determining the allowance for the acquired loan portfolio. Accounting for Acquired Loans under ASC Topic 310-30 ASC Topic 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality (ASC 310-30), provides guidance for accounting for loans acquired in a business combination that have experienced a deterioration in credit quality since origination for which it is probable that the purchaser will be unable to collect all contractually required payments, including both principal and interest. Such purchased loans are considered impaired. In assessing credit quality deterioration, we must make numerous assumptions, interpretations and judgments using internal and third-party credit quality information to determine whether or not it is probable that we will be able to collect all contractually required payments. This is a point in time assessment and inherently subjective due to the nature of the available information and judgment involved. Evidence of credit quality deterioration as of the acquisition date may include statistics such as past due and nonaccrual status, recent borrower credit scores and loan-to-value percentages. Those loans that qualify under ASC 310-30 are recorded at fair value at acquisition, which involves estimating the expected cash flows to be collected, both principal and interest, discounted at the prevailing market rate of interest. Accordingly, the associated allowance for loan losses on these loans is not carried over at the acquisition date. ASC 310-30 also allows purchasers to aggregate acquired loans into loan pools with common risk characteristics and apply a composite interest rate and estimate cash flow expectations for all loans in the pool. We elected to apply ASC 310-30, by analogy, to loans acquired in our Talmer, Lake Michigan, Monarch, Northwestern and O.A.K.Financial Corporation ("OAK") acquisitions and, therefore, we follow the accounting and disclosure guidance of ASC 310-30 for all of these acquired loans. 42